The First Bancorp Inc (NASDAQ:FNLC) is currently trading at a trailing P/E of 17.8x, which is lower than the industry average of 18.3x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for FNLC
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for FNLC
Price-Earnings Ratio = Price per share ÷ Earnings per share
FNLC Price-Earnings Ratio = 30.58 ÷ 1.715 = 17.8x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to FNLC, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. FNLC’s P/E of 17.8x is lower than its industry peers (18.3x), which implies that each dollar of FNLC’s earnings is being undervalued by investors. As such, our analysis shows that FNLC represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy FNLC immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to FNLC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with FNLC, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing FNLC to are fairly valued by the market. If this is violated, FNLC's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on FNLC, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.
Are you a potential investor? If FNLC has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on First Bancorp for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.